Bollinger Bands Trading Strategy: Explained

Ganesh Adhikari

Bollinger bands are yet another very effective and informative technical indicators that signify the motion of the market. Bollinger bands were introduced and developed by popular and successful technical trader John Bollinger for identifying the better timings for entry and exits from the capital market. Bollinger bands consist of three trend lines: a simple moving average (usually 20 days) in the middle assisted by its two standard deviations in the positive and negative directions forming the upper and lower band. Bollinger bands can effectively tell whether the stocks are being overbought or oversold like RSI (Relative Strength Indicator).

Caution: Bollinger bands are not to be used on their own (solitary) but must be used to confirm the price movement with the help of other technical indicators.

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Calculation of Bollinger bands

First, we calculate a simple moving average for a stock, (10 days moving average for short term, 20 days moving average for medium-term and 50 days moving average for long-term). Then, calculate the standard deviation over the same periods as the simple moving average. Here, standard deviation measures the dispersion (spreading) of price values from the average value which is calculated by taking the square root of variance.

Now, multiply the standard deviations by 1.5 (short term), 2 (medium-term), or 2.5 (long term). Finally, add and subtract thus obtained multiple of standard deviation to the moving average for upper band and lower band respectively.

Working and Trading Strategies of Bollinger bands

1. Overbought and Oversold Strategy

The most basic and common strategy that can be used in stock picking using Bollinger bands is by identifying the overbought and oversold situation in the market with the help of the bands. The strategy can be applied as:

BUY: when the price of the stock falls below the lower band (indicating the oversold condition), the price is eventually bound to move towards the middle or the upper band.

SELL: when the stock price breaks above the upper band, it indicates the overbought situation and thus the prices will retrieve back (pullback) towards the middle or the lower bands.

The price movement in between the bands is compared to the bounding ball. The strategy is based on the fact that if the prices move substantially away from the mean position, they will eventually move back to the original or mean range.

Caution: Bollinger Bands don’t always give accurate buy and sell signals. When in a strong trend, the indicator might signal overbought or oversold signals too soon. Similarly, it might not be effective to signal the major trend reversal.

2. Breakout Strategy

A strong trend continuation is signaled if the price falls below or breaks above the moving average band with strong volume and continues to move in the same direction. Similarly, the breakout can be confirmed using RSI (relative strength Indicator) and MACD (Moving average convergence divergence). Further, when the prices break out of the lower or upper band and if they continue in the same direction, it signals a strong continuation pattern. Breakout strategy can also be applied using squeeze pattern as discussed in the next point.

3. Squeeze Strategy

In Bollinger bands, a squeeze occurs when all the bands come close together, indicating the consolidation phase in the market. The squeeze means the low volatility in the market and potentially high volatility is waiting shortly providing trading opportunities when the bands move wider. When the squeeze phase is over, the price tends to make a healthy move in either direction. When this move is supported by high volume the new trend is confirmed in the breakout direction as many traders are showing confidence in the breakout movement.

The ideal time to buy is when the price breaks through the upper band and sells when the price falls below the lower band when the consolidation phase seems to be over. Stop-loss is suggested to place outside the consolidation line on the opposite side of the breakout.

4. Bollinger Bands with RSI

Relative strength index (RSI) is a technical indicator that measures the strength of current price trends in comparison to previous price trends. The oscillator tool is displayed as a line graph that moves between two extremes (ranging between 0 and 100). When RSI is combined with Bollinger Bands, traders can spot the buy and sell positions in the chart.

When the RSI is above 70 and the stock price reaches the upper band of a Bollinger Band price channel, the trader may sell the securities or stocks as it interprets the stock is overvalued. Conversely, When the RSI is below or around 30 and the stock price reaches the lower band of a Bollinger Band price channel, the trader may place buy the securities or stocks as it interprets the stock is undervalued or under bought.

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Pros of Bollinger Bands

1. Bollinger Bands best depicts the volatility in the market, thus helping to find entry and exit positions for traders.

2. Bollinger Bands are user-friendly, easy to apply, and can be used in combination with other useful technical indicator tools.

3. Bollinger Bands can identify how powerful the current market trend momentum is and possible pullback or breakout.

4. It helps to discover new opportunities to make financial gains in a short time.

Limitations (Cons) of Bollinger Bands

1. Bollinger Bands (BB) are reactive, not predictive. Bollinger Bands are a lagging indicator, so they do not predict the upcoming trends.

2. Bollinger Bands are not standalone trading tools. John Bollinger (developer of Bollinger Bands) has said the bands must be used in combination with other non-correlated technical analysis tools that provide more direct market signals such as moving average divergence convergence (MACD), on-balance volume, and relative strength index (RSI).

3. Bollinger Bands standard settings might not work for all traders. Each trader must uniquely identify the settings that best fit his/her trading strategy.

Conclusion

Bollinger Bands can be effectively used by both long-term and short-term traders by identifying the market momentum or trend exhaustion or trend reversal. Traders can adjust the SMA and standard deviation assumptions as they see fit which makes it very flexible to use. This user-friendly technical indicator has especially proved to be of significant importance to short-term traders as it determines the extreme short-term prices in the market. Bollinger Bands help the traders to exploit the volatility of the market to their advantage by providing information about the market condition (oversold or overbought).

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